A controversial policing tactic could actually do some good on Wall Street

I assumed it was about a crisis in the financial markets, something bad happening in Asia. No, it was about a strip club. "Dude, turn on the TV news. Giuliani is raiding the Harmony Theater."

The Harmony Theater was a two-level dive club in lower Manhattan, popular among Wall Streeters because it bent rules. It was a place where almost anything, including drugs and sex, could be bought in the open.

When I turned on the TV I saw a swarm of close to a hundred police, many in riot gear, escorting handcuffed strippers and sad-looking clients into waiting police vans. No traders, or at least none that my friends or I knew, were arrested that night.

Zero tolerance was the first big application of "broken windows," a theory of policing first argued in a 1982 Atlantic article by James Q. Wilson and George Kelling. They suggested that by targeting minor crimes, "fixing broken windows," police could reduce the sense of disorder that often causes more serious crimes.

"One unrepaired broken window is a signal that no one cares, and so breaking more windows costs nothing," they warned.

Broken windows proposed that disorderly behavior left unchecked, even if it seemed harmless, made cities "vulnerable to criminal invasion." Its implementation by Giuliani was an attempt to lower crime by fundamentally changing the behavior of New Yorkers and the culture of New York.

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It would, for the next 20 years, reshape the average New Yorker's life. Rule breakers, no matter how inconsequential, would be arrested and jailed. Gone, after repeated arrests and considerable fines, was anyone who bent or broke the law (well, anyone in minority and lower-income neighborhoods, that is), no matter how gray or small the offense: The squeegee men, folks littering, anyone with marijuana, graffiti artists, prostitutes, panhandlers, and subway-fare jumpers.

Spencer Platt/Getty Images
At the same time an opposite policy, launched out of Washington, reshaped Wall Street. While the average New Yorker was being subjected to increased police scrutiny, under the theory that individual liberty can collectively be corrosive, financial firms in Lower Manhattan were being subjected to almost no scrutiny, under the theory that individual liberty, especially when applied to businesses, can be collectively beneficial.

My banker friends and I benefited from both policies. We were ignored during the day by regulators and free at night from squeegee men and muggers.

Wall Street and New York City boomed. The firm I joined in '93 was an investment bank with 5,000 employees and $110 billion in investments. Fourteen years later it had grown, through acquisitions and mergers, into a financial conglomerate with more than 200,000 employees and $2.2 trillion in investments.

That growth in the financial sector culminated in the massive financial crisis of 2008, which bankrupt my firm and almost bankrupt the country. Following the crisis politicians were finally forced to deal with the reality that it was Wall Street that was out of control and had too many broken windows.

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In '93 I joined a Wall Street that was going out of style, a Wall Street where graying partners were served lunches on fine china at their desks by waiters. I joined a Wall Street that celebrated birthdays with strippers on the trading floor and successes with Cuban cigars.

screengrab from "Wall Street"
The old Wall Street, filled with medium-size private investment partnerships, had been molded by the financial regulation following the Great Depression, which set strict limits on who could do what. By '93 these firms were almost entirely gone, being bought up, merged, and replaced by large public megabanks that followed a wave of banking deregulation in the '80s.

Partnerships were quirky and often eccentric places (think Trading Places), but had a structure that incentivized financial caution. Employees were required to keep their money in the company, so if the firm failed, everyone failed, resulting in a degree of self-policing.

The newer megabanks paid employees yearly, and allowed them to mostly do with their money what they wanted, leaving little financial stake in their banks. Size also diminished the sense of community; many firms now had employees well into the hundreds of thousands. For some, the only thing that now linked them to the banks that employed them was the yearly bonus and a few sad cheerleading emails from HR.

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The relationship to customers also changed. As the industry expanded the distance between bankers and borrowers increased, hidden behind increasing layers of financial engineering. Borrowers no longer walked into a bank to take out a loan. They walked into a lending company in a strip mall, which then sold their loan to a third party, who then sold it to another middleman, and so on, until it eventually was bought by a Wall Street bank who would then put it in a big pile, slice, dice, tranche, and CDO it, and then finally sell it to distant and often foreign investors. Or, as many did, just keep it as one of the bank's ever-growing investments.

In this era of complete regulatory permissiveness, Wall Street morphed into floor after floor of traders, like myself, sitting behind walls of computers, watching numbers flash, moving other numbers around spreadsheets, and betting on them all. If the bets worked out, they would get paid millions. If they lost, they only got paid hundreds of thousands. Nobody ever had to give anything back to the bank, or to the customer, no matter how badly they erred.

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Wall Street was a huge digital neighborhood, almost completely unpatrolled, and steeped in a culture with a diminished sense of fiduciary responsibility to the firm, the customer, or really anyone. It was, in language Giuliani would understand, an environment filled with broken windows, and conducive to abuse.

A man walks past the New York Stock Exchange during the morning commute April 30, 2014.
REUTERS/Brendan McDermid
One of the intellectual frameworks of the broken-windows theory was a psychological experiment from 1969 by Philip Zimbardo, in which a car, stripped of any ownership (plates removed, hood up) was placed in a bad neighborhood in the Bronx, and in a good one in Palo Alto. The car in the Bronx was quickly surrounded by residents, stripped, and left denuded except for a steel frame. Twenty-four hours later it became an impromptu jungle gym for kids. The car in Palo Alto was left alone until Zimbardo himself started vandalizing it, then others joined.

The lesson, according to broken windows, was that "the appearance of disorder begets actual disorder—and that any visual cues that a neighborhood lacks social control can make a neighborhood a breeding ground for serious crime," wrote journalist Daniel Brook in a piece critical of the theory. Put simply, don't leave a car unattended in the South Bronx.

A similar adage applied to Wall Street: Don't leave a rule unattended. By 2001 you could walk into any Wall Street bank and give them a new regulation or a rule. The result would be the same. Within a few weeks the rule would be surrounded by a scrum of lawyers and traders, stripped of any real meaning, denuded of all except the most absurdly benign interpretation, and the remaining flimsy frame used by traders as an impromptu platform for making money.

Wall Street had become a neighborhood that feasted on loose regulations and rules. It developed new products to evade the letter of the law. Derivatives, complex financial products used to "transform cash flows," exploded, becoming a tool to shift money away from regulators or taxes. They were used to move money among countries, between long and short capital gains, switch it from debt into equity, interest into dividends.

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By 2001 housing was the perfect target for Wall Street: a huge market that was a tangle of rules and regulations, of quasi-guaranteed government agencies, and customers desperate to borrow.

Wall Street went to work bending rules, splitting hairs, exploiting loopholes, lobbying politicians, and building corrupt relationships, hiding all of it behind a layer of complexity. By 2007 Wall Street and the housing market were enmeshed, and banks overloaded with overvalued assets tied to an overvalued housing market, much of it hidden from regulators by derivatives. When the housing market collapsed, Wall Street collapsed even quicker, wiping out profits from the prior decade in a matter of months. The rest of the U.S. was dragged down into a deep recession that it is yet to fully recover from.

Henny Ray Abrams/AP
In the aftermath of the crisis, an outraged public demanded things. Angry speeches were given, congressional hearings held, and fines close to $100 billion levied for the most extreme and transparent cases of fraudulent lending practices.

Legislation to reform banking practices and the mortgage market was also passed, mostly notably the Dodd-Frank Act. It was a well-intentioned attempt to address the fundamental problems that contributed to the financial crisis. But Dodd-Frank is itself a huge set of complex rules, and played into the hands of Wall Street.

It was like building a sprawling glass house in a neighborhood filled with broken windows. Since its passing in 2010, regulators have watched as the shiny new bill has been surrounded by the financial industries lawyers, lobbyists, and sympathetic politicians, and much of it either amended, reinterpreted, or whole parts rewritten to favor banks.

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Frustrated, regulators have started to shift their focus, realizing that maybe the only way to regulate someone who thrives on ducking regulations is to bring something like broken-windows policing to Wall Street in hopes of changing its culture.

What is the financial equivalent of rounding up the squeegee men, graffiti artists, and those smoking joints in front of the police station? It means going after the easy targets, the transparent businesses where the abuses were well documented.

Precarious window washing.
Brendan McDermid/Reuters
Doing so has resulted in a bevy of investigations and scandals named after acronyms: LIBOR, FXfix, and ISDAfix. Despite the names, all are routine and boring parts of banking. In the first two cases wrongdoing was clear, admitted to, and massive fines of close to 50 billion were levied against the major banks. The third case is still in its infancy.

And that is what regulators care about, and why they are now following the playbook from broken windows. They want to change the culture of permissiveness and to finally tend to long untended behavior, in the hope of affecting serious fundamental change. From the 1982 Atlantic article:

"This wish to "decriminalize" disreputable behavior that "harms no one" is, we think, a mistake. Arresting a single drunk or a single vagrant who has harmed no identifiable person seems unjust, and in a sense it is.

But failing to do anything about a score of drunks or a hundred vagrants may destroy an entire community. A particular rule that seems to make sense in the individual case makes no sense when it is made a universal rule and applied to all cases. It makes no sense because it fails to take into account the connection between one broken window left untended and a thousand broken windows."

New York Stock Exchange. Pedestrians stop and view the electronic display of the New york Stock Exchange activitiy in the window of Fidelity Investments at Park Avenue and 51st Street after the opening of the NYSE early Tuesday, October 20, 1987.
AP Images
It is unclear if broken windows for Wall Street will work. Penalizing the corrupt businesses you can get your hands on might slow down the more opaque and dangerous businesses you can't. It might make them less abusive of rules and regulations.

It might help to forge a renewed fiduciary responsibility of bankers to customers, clients, and their own firms. Or it might only provide incentive to Wall Street to bury its crimes further, shielding them behind more complexity.

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It might also be just scapegoating, an exercise in making the public feel like something is being done while leaving the more damaging structural issues unchanged. Employee compensation is still incentivized toward short-term and capricious risk taking and the megabanks are still too big to fail.

Twenty years after the New York City police force started applying broken windows to address street crime, the benefits are being questioned. The costs, in human terms, have been huge, with record numbers of citizens, mostly minorities, incarcerated, and untold others denied basic constitutional rights.

flickr/eliz.joy22
If a broken-windows approach to Wall Street doesn't work, if it doesn't change the culture, decrease the fraud, and doesn't decrease the risk and consequences of future financial crises, the cost in human terms will have been close to nothing.

So far the only consequences for Wall Street bankers has been fines levied at their companies. The number of bankers whose personal lives have been disrupted is tiny.

More people will probably have served time from that first Giuliani raid on the Harmony Theater in '94 than will serve time for all the acronym scandals. That is not a very high threshold though, because nobody has yet to serve time for the acronym scandals. Just like almost nobody has served time for any part in the financial crisis.

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And that is the biggest difference in all of this: Bankers get fines. Everyone else goes to jail.